Commodities Vs The Dollar

Our adage of "if you get the US dollar right, you get a lot of other things right" rings true today. With the US dollar up for 8 out of the last 9 weeks, commodities have had a rough ride. September was a particularly hard month as the CRB Commodities Index trailed lower as the dollar gained strength.

EARNINGS SLOWING UPDATE: HOPE SPRINGS ETERNAL

Roughly 96% of the way through the Q3 earnings season, 58.7% of S&P 500 companies have missed on the top line and 30.7% have missed on the bottom line (478 total). That compares with 57.8% and 26.8%, respectively, in 2Q12. If the season wraps up as things currently stand, 3Q12 will have reported the lowest percentage of companies beating on the top line since 1Q09.

72% of companies that have issued 4Q12 EPS guidance have issued projections below the mean EPS estimate. That compares with a ratio of 80% on the negative side at this time during the previous earnings season. Despite this improvement, we continue to warn that consensus estimates for 4Q12 and 2013 remain dramatically inflated relative to any reasonable economic GROWTH scenario.

Bloomberg consensus still has S&P 500 constituent EPS growing an average of +7.1% YoY per quarter over the NTM vs. +0.9% YoY in 3Q12 and a trailing four quarter average of +3.1% YoY. While down from a projected quarterly average NTM EPS growth rate of +9.9% YoY when we first called out consensus’ poor modeling technique back on OCT 8, we still contend these estimates remain out to lunch with respect to any reasonably objective estimate of future corporate profit growth stemming from Bayesian logic.

One of the biggest proactively predictable fundamental risks to EPS growth we continue to see domestically is corporate cost cutting. Already, we’ve seen business investment contract at a -1.3% seasonally-adjusted annualized rate in 3Q12, the first sequential decline since 1Q11. Per a recent WSJ report, half of the 40 largest publically traded companies have announced plans to “curtail capital expenditures this year or next”.

Equity bulls remain hopeful that this round of EPS engineering is more akin to the early 2004 and early 2011 slowdowns, rather than the early 2001 and early 2008 CapEx slowdowns, which brought forth the last two major declines the corporate profit cycle.

WHERE WE STAND

Roughly 96% of the way through the Q3 earnings season, 58.7% of S&P 500 companies have missed on the top line and 30.7% have missed on the bottom line (478 total). That compares with 57.8% and 26.8%, respectively, in 2Q12. If the season wraps up as things currently stand, 3Q12 will have reported the lowest percentage of companies beating on the top line since 1Q09.

From a growth rate perspective, S&P 500 constituent revenue growth slowed to +2.2% YoY in 3Q12 on a median basis from +2.7% YoY in 2Q12. S&P 500 constituent operating margin growth accelerated to +16bps YoY in 3Q12 from +2bps YoY on a median basis. From a forward-looking perspective, S&P 500 constituent sales growth is projected to average +4.1% YoY on a median basis, per quarter, over the NTM, while operating margins are projected to expand an average of +97bps on a median basis, per quarter, over the NTM. Both growth rates suggest marked accelerations from the latest trends over the intermediate term.

WHERE WE’RE HEADED

Continuing our peak into the future, 72% of companies that have issued 4Q12 EPS guidance have issued projections below the mean EPS estimate. That compares with a ratio of 80% on the negative side at this time during the previous earnings season. Despite this improvement, we continue to warn that consensus estimates for 4Q12 and 2013 remain dramatically inflated relative to any reasonable economic GROWTH scenario.

Bloomberg consensus still has S&P 500 constituent EPS growing an average of +7.1% YoY per quarter over the NTM vs. +0.9% YoY in 3Q12 and a trailing four quarter average of +3.1% YoY. While down from a projected quarterly average NTM EPS growth rate of +9.9% YoY when we first called out consensus’ poor modeling technique back on OCT 8, we still contend these estimates remain out to lunch with respect to any reasonably objective estimate of future corporate profit growth stemming from Bayesian logic.

Shockingly, Bloomberg consensus is not out to lunch with their US and Global GROWTH estimates for 2013; this strongly supports our belief that bottom-up analysts are uniformly praying for a dramatic acceleration in stock buybacks, M&A and USD debauchery.

Not that gaming sell side analysts is a new strategy, but we must never forget that the sell side is paid to hope now and blame macro later when it comes to modeling bottom up estimates. Conversely, we will continue to use a rigorous top-down approach to front-run proactively predictable fundamental risks.

One of the biggest proactively predictable fundamental risks to EPS growth we continue to see domestically is corporate cost cutting. Already, we’ve seen business investment contract at a -1.3% seasonally-adjusted annualized rate in 3Q12, the first sequential decline since 1Q11. Per a recent WSJ report, half of the 40 largest publically traded companies have announced plans to “curtail capital expenditures this year or next”. Equity bulls remain hopeful that this round of EPS engineering is more akin to the early 2004 and early 2011 slowdowns, rather than the early 2001 and early 2008 CapEx slowdowns, which brought forth the last two major declines the corporate profit cycle.

This we know: corporate profits are, in fact, cyclical. We also know that corporate margins have been asymmetrically stretched to all-time peaks. The latter suggests to us that any further “improvements in corporate efficiency” are heavily skewed towards being a drag on future top line growth for the cost-cutting company, as well as a contemporary drag on top line growth for companies in the respective supply chain(s). As we’ve remarked in recent notes: broader economic growth suffers when corporate executives shift their focus en masse to playing “pin the tail on the EPS estimate” by embarking on aggressive cost-cutting strategies to appease shareholders (many of whom happen to be corporate executives themselves).

In the absence of robust top line growth, we submit that corporate executives can and will continue to pull various levers to get themselves and other shareholders paid. The risk, however, is that their micro-level tactics risk perpetuating a global economic slowdown initially brought on by a bleak macro environment and outlook. Keep that in mind when you press management teams on how they plan to “hit the numbers” over the intermediate term.

WHERE WE’VE BEEN

This is the third installment of our analysis of the 3Q12 earnings season. Please see below for the previous reports, as well as our initial #EarningsSlowing presentation as introduced as part of our 4Q12 Macro Themes:

#EarningsSlowing - Corporate margins are stretched on numerous metrics. Even with financial engineering we suggest there's limited upside in the results from here. We expect the gravity of global growth slowing and inflation accelerating to impact consumer and corporate P&Ls alike.

Bubble #3 - Following the tech and housing bubbles, the charts of Bernanke's Commodity Bubble could not be more crystal clear. So when does this bubble pop? We'll continue to take our cues from the U.S. Dollar and weigh the influence of policy and fundamentals across the complex.

Keynesian Cliff - We wrap together an analysis of the U.S. Presidential race with the nearing US fiscal cliff. We discuss the impact of investors potentially shifting their attention away from Europe and back to the U.S.'s ugly imbalances.

As we have stressed in recent weeks, the 3Q12 earnings season will likely be the most dour since the Global Financial Crisis and, perhaps more importantly, consensus estimates for NTM EPS growth are simply too rich – particularly in light of aggressive margin assumptions embedded in consensus expectations.

As such, the direction and tone of corporate guidance will likely be as important to stock performance as it has ever been in the post-crisis period. In this regard, the next few months will definitely be a stock-picker’s environment for those seeking to meet year-end performance targets.

As we highlighted in recent notes, a key risk that could equate to an incremental drag on global growth over the intermediate term is an acceleration of corporate cost-cutting initiatives across both domestic and international corporations. Moreover, recent company commentary suggests this trend is already underway.

Roughly 80% though earnings season, it’s clear to see that 3Q12 has shaped up exactly as we had laid out in our #EarningsSlowing theme: very bad.

Consensus remains out to lunch with their forward revenue, operating margin and EPS growth estimates. When you combine the negative trend in corporate guidance with the potentially-precarious Global Macro setup (potential US recession; no Chinese stimulus; Europe continues to contract), it’s easy to anticipate a scenario whereby those estimates have to be revised down hard and fast at some point over the intermediate term.

Aggressive estimates for operating margin expansion puts a great deal of pressure on corporate management teams to accelerate material cost-cutting initiatives like we’ve seen at UBS, DOW, AMD, RIO, FDX and CMI (to name a few). While that may appear good for a single company’s earnings outlook in the short term, the reality is that when corporations are engaged in cost-cutting en masse, GDP growth tends to slow materially; this perpetuates top line weakness across the corporate sector in a reflexive manner.

Darius Dale

Senior Analyst

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11/19/12 12:40 PM EST

Getting To Know JACK

Last week, Hedgeye held its bi-annual Best Ideas call for institutional clients. On the call, we discussed our top ideas from each sector that we cover. We’re presenting each idea in a series of videos starting today with Restaurants Sector Head Howard Penney’s bullish call on Jack In The Box (JACK).

It’s important to note that Penney cautions against running out and buying JACK before they report on November 20. The company has several characteristics that make it attractive including stable cash flow and growth opportunity in the form of Qdoba. Jack In The Box remains the company’s mature concept while Qdoba has significant growth ahead of it. JACK also has upgraded its core asset base so capital expenditures are declining and behind the company going forward.

Watch the video we’ve posted for Penney’s full take on Jack In The Box.

Hedgeye Statistics

NOV IL LICENSING UPDATE

IL approvals decelerate in November

Following its board meeting, the Illinois Gaming Board (“IGB”) released a list of all licensees as of November 16th. The list included 605 licensed establishments, implying approval of an incremental 108 establishments in November. This marks a big deceleration over the 164 granted in October. To date, there have been no establishment licenses revoked and 25 establishments have been denied licensure. There has been one terminal operator who had its license revoked along with one manufacturer and 22 terminal operators that have been denied licensure. Currently, there are 2,659 establishments pending approval, up 6% from October.

Each location can have a maximum of 5 machines so 605 approved locations imply a current maximum market size of 3,025. On October 10th, after 3 weeks of testing, the IGB allowed 65 establishments to go live with VGT gaming. In the September quarter, BYI and WMS recognized several hundred game sales into IL. In the December quarter, most suppliers should be able to recognize revenues associated with placements in this market.

Our best guess is that 3,000 VGTs will be shipped to IL in 2H2012, and by the end of 2013, the market should comprise of about 10,000 units. Given that we are just in the 6th month of establishment approvals, it’s too early to say whether these estimates will come to fruition. We expect that most of the VGT sales (upwards of 75%) will come with some sort of financing, but most will be accounted for as for-sale machines.

Our understanding is that ASPs should be around $12k range. The consensus is that VGTs will win about $100 on average per day, with a large range depending on the location. We believe that distributors receive a 10-15% cut of the purchase price as their commission, with the big suppliers paying on the low end of that range and some of the smaller guys paying at the higher end of that range. Typically, distributors take the machines on a consignment basis, meaning that suppliers cannot recognize revenues until the machines are placed in the establishments.

Because A) 1380 = an intraday price, not a closing price and B) closing prices need to confirm for consecutive days.

Fortuitously, we don’t have any index shorts on right now (covered 10 short positions last week), so what I’ll do now is wait for the fire to breathe here and give us higher prices. If it doesn’t, I know what to do then as well.

Across our core risk management durations, here are the lines that matter to me most:

Intermediate-term TREND resistance = 1419

Immediate-term TRADE resistance = 1398

Long-term TAIL support = 1364

In other words, your new Risk Range is 1 of 2:

1 (if TAIL holds)

1 (if TAIL breaks)

That doesn’t make this easy. It just outlines my decision making tree. Risk managing based on conditional probabilities supports this process, however dynamically prices change.

KM

Keith R. McCullough Chief Executive Officer

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11/19/12 10:37 AM EST

Energy: Decline In Capex

Exploration & Production (E&P) capital expenditures are negative on a year-over-year basis for the first time since 2009. The decline comes at a time where producers have exhausted their 2012 budgets due to a cost inflation, poor budgeting and a desire for faster drill/completion times. Street consensus for 2013 capex aims for a decline of -0.4% year-over-year but we believe that’s a bit optimistic after several companies have suggested that budgets will be lower.

One thing to remember is the sensitivity of commodity prices in the E&P sector. With the dollar rallying for 8 of the last 9 weeks, the price of crude oil is certainly poised to fluctuate quite a bit.

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